Friday, July 31, 2009

Both the New York Times and the Financial Times have reported that Wall Street banks that received TARP funds gave out billions of dollars in pay bonuses. Over 5000 employees earned over $1 million in bonuses during one of the worst financial crises. Now the question that some are asking is why are bonuses being paid to individuals when the firms financial performance was/is so poor? I think that this is a legitimate economic question to ask.

Before I tackle a possible solution, I want to be clear that I am not advocating capping pay or bonuses per se. In other words, I think that employers should be able to pay their employees within the law (i.e. minimum wages - which do not apply in this case) and as they see fit (based on market forces). So I am not in favor of regulating payroll or salaries, but at the same time I have a hard time coming up with an economic justification to the bonuses being paid to those employees given the economic hardships these banks have caused to a large number of individuals in our economy.

The problem is that given the large TARP subsidies (that these firms were given by the US government - which represent US citizens who ultimately will have to pay for the bailout), why are firms that received subsidies paying out bonuses? In other words, if the government is providing relief to these poor performing banks, shouldn't those banks act in a more socially responsible way - given that all of their receipts are not generated in the marketplace, but rather a substantial portion are generated by the government? I would have to answer, "yes". Thus we have an incentive problem in how Wall Street bankers bonuses are paid out. I am not sure if this is original, and do not recall reading this elsewhere, but my solution would be for banks not to be restricted in their pay or bonus decisions directly. Rather we can take a page from Major League Baseball, in terms of a payroll tax on firms receiving government subsidies.

I would propose that for each dollar in bonuses (or increase in salary) given to those in these firms, the firm has to pay back to the government a dollar. Thus we have a "tax" on the payroll and bonuses given out to those firms receiving government subsidies. Firms will then have to internalize the cost of salary increases or bonuses paid out in making those decisions.

I realize that this is not a perfect solution - what about stock perks, etc., but I think those types of re-numeration could also be included in this type of policy, and lead to a more socially responsible outcome.